GREEN MOUNTAIN COFFEE ROASTERS’ PROFITS: OVERSTATED OR MISUNDERSTOOD

Thursday, July 10 2012

DISCLAIMER
The information contained herein reflects the views of LongShortTrader (“LST”) as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. LST has an economic interest in the price movement of the securities discussed in this presentation, but LST’s economic interest is subject to change without notice. All information provided in this presentation is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. In addition, there can be no guarantee that any projection, forecast or opinion in this presentation will be realized. All trade names, trademarks, service marks, and logos herein are the property of their respective owners who retain all proprietary rights over their use. This presentation is confidential and may not be reproduced without prior written permission from LST.

INTRODUCTION Green Mountain Coffee Roasters (“GMCR”) has long claimed to be a razor, razor blade business in its 10Ks, 10Qs, Investor Presentations, Conference Calls, etc. “The Company sells the majority of Keurig single-cup brewers approximately at cost, or sometimes at a loss when factoring in the incremental costs related to sales, including fulfillment charges, returns and warranty expense.” – 2011 10K Based on a recently released SEC Comment letter and other information, LST believes that either: (A) GMCR’s business is misunderstood, its economics misrepresented; the claim that the company sells “brewers at cost” a la “razor, razor blade” is completely FALSE. In fact, it actually makes a lot of money on brewers. OR (B) GMCR’s 2011 gross profits and earnings are overstated by $100 million and $160 million respectively (more or less). 2011 EPS is more like $0.60, not $1.30, which means the PE ratio is more like 35.9x, using Wednesday’s closing price of $21.71 per share. REPORTED GROSS MARGINS DON’T MAKE SENSE, IMPLY A VERY LARGE OVERSTATEMENT

Herb Greenberg, “CNBC senior stocks commentator, journalist, hype-buster, creator/proprietor of the ORIGINAL Hostile React-o-Meter” asked the question shown above on Monday, July 9. LST has combed through dozens of filings, foot notes, etc. and believes Greenberg (and others) are right to question GMCR’s gross margin and gross profit figures. In fact, LST believes it’s even worse than Greenberg suggests, as GMCR’s reported gross margins don’t make any sense nor are they consistent with other information the company has provided for years. LST tried to re-create GMCR’s reported gross margin for 2011. No matter how much LST plays around with the numbers (some refer to this as “sensitivities analysis”), the results all lead to the same conclusion: Gross profits/margins for 2011 appear to be overstated materially, to the tune of 6.3% of sales. LST assumes the following for the 2011 numbers: 1. K-cup gross margin is 30%, based on information provided by GMCR in a SEC comment letter released Monday. 2. “Brewers and Accessories Gross Margin” is 10%, based on a blended average of 0% brewer gross margins and 67% gross margin for accessories. 3. ‘Other Products’ gross margin is 40%, based on GMCR’s historical gross margins prior to its acquisition and consolidation of Keurig. 4. ‘Royalties’ gross margin is 100%.

The table below summarizes the assumptions and the resulting excess gross margin:
GROSS MARGIN BY PRODUCT CATEGORIES
2011

K-Cup®Portion Packs Gross Margin Brewers and Accessories Other Products Royalties Gross Margin, as Calculated Reported Gross Margin Excess, Unexplained margin:

30.0% 10.0% 40.0% 100.0% 27.8% 34.1% 6.3%

Comments: See SEC Comment letter. Assume "selling brewers at cost" = 0% G.M. Assume accessories is a high margin product. Using average GMCR gross margin pre-Keurig acquisition. Going back to the 1990s. Whatever number you use, it's an immaterial number. See revenue amount.

This is the pre-tax overstatement. As % of sales, so the dollar amount is 6.3% * 2011 sales.

The above analysis used ‘Net Sales By Product Categories’ provided by GMCR in its 10K (shown below):
NET SALES BY PRODUCT CATEGORIES
2011

K-Cup®Portion Packs Gross Margin Brewers and Accessories Other Products Royalties

$1,704.0 $524.7 $414.0 $8.2 $2,650.9

Note that the excess gross margin estimation was done using 2011 numbers, but LST believes similar apply to 2009 and 2010’s numbers as well.
GMCR REPORTED GROSS MARGINS
2009 2010 31.4% 2011 34.1%

Gross Margin:

31.2%

IMPACT ON EARNINGS If the gross margin estimated by LST more accurately reflects GMCR’s economics than its reported gross margin, the impact on earnings is very material, i.e. around $100 million:
EARNINGS OVERSTATEMENT REPORTED
2011

ESTIMATED
2011

Comments:

Net sales $ 2,650,899 $ 2,650,899 Cost of sales Gross profit Selling & operating expenses General & administrative expenses Operating income Other income (expense), net Loss on financial instruments, net Loss on foreign currency, net Interest expense Income before income taxes Income tax expense Net Income $ 1,746,274 904,625 348,696 187,016 368,913 648 (6,245) (2,912) (57,657) 302,747 (101,699) 201,048 $ 1,913,429 737,470 See 'Gross Margin by Product Categories' table. 348,696 Assume no opex understatement to simplify 187,016 and focus on gross profit for now. 201,758 648 (6,245) (2,912) (57,657) 135,592 (45,548) Calculated using same tax rate as the reported figure. 90,044 True net income seems less than half of reported net income.

The impact on earnings per share (“EPS”) is just as bad, as LST’s estimate for 2011 EPS is less than 50% of reported 2011 EPS:
EPS OVERSTATEMENT REPORTED
2011

ESTIMATED
2011

Basic EPS Diluted EPS Price (7/11/12 close): PE Ratio:

$1.36 $1.31 $21.71 15.9x

$0.61 $0.58 35.9x

IF REPORTED GROSS MARGINS ARE CORRECT, THEN WHAT? The above analysis attempts (and fails) to re-create GMCR’s reported gross margins, instead suggesting GMCR’s reported gross margins are substantially overstated. Let’s assume the following, for argument’s sake: 1. 2. 3. 4. The reported 2011 gross margin of 34.1 % is accurate. K-cup gross margin is 30%. ‘Other Products’ gross margin is 40%. ‘Royalties’ gross margin is 100%.

That raises the question: what is the “Brewers and Accessories” gross margin? Fortunately one does not need a Mathematics PHD from MIT or a CPA from Vermont to answer (Granted, GMCR CFO Frances Rathke has neither, despite falsely claiming to be a CPA since first joining the company in 2003):
2011

K-Cup®Portion Packs Brewers and Accessories Gross Margin Other Products Royalties Reported Gross Margin

30.0% 41.7% 40.0% 100.0% 34.1%

Comments: See SEC Comment letter. Note that the gross margin as calculated exceeds k-cup gross margin. See comments from "GROSS MARGIN BY PRODUCT CATEGORIES" table. Whatever number you use, it's an immaterial number. See revenue. They claim "razor, razor blade" yet total G.M. is less than Brewer G.M. ?

According to LST’s calculations, the implied “Brewers and Accessories Gross Margin” is 41.7%, or higher than the K-cup gross margin. In fact, it is higher than any other product category (excluding royalties)! Does 41.7% “Brewers and Accessories” Gross Margin make any sense given the company has claimed: “Approximately 96% of Keurig brewers shipped in fiscal 2011, were sold to the AH channel approximately at cost, or sometimes at a loss, factoring in the incremental costs related to sales. With respect to the Keurig single-cup AH system, we are continuing to pursue a model designed to penetrate the marketplace, a component of which is to sell brewers at affordable consumer price points in order to attract new customers into single serve coffee.” – 2011 10K “The Company sells the majority of Keurig single-cup brewers approximately at cost, or sometimes at a loss when factoring in the incremental costs related to sales, including fulfillment charges, returns and warranty expense.” – 2011 10K

POSSIBLE EXPLANATIONS LST looked through Greenlight Capital’s GAAP-uccino presentation, after doing all the above work. Greenlight’s “Capital Expenditure” slides look particularly interesting, given LST’s estimate of around $100 million overstatement in GMCR’s 2011 gross profit is within the range of Greenlight’s unexplained capex estimate of $103 - $186 million (shown below and on the next page; note that this report only covers gross profit overstatement, and does not address the possible understatement of operating expenses):

Even if Greenlight or LST were off by 25%, 50%, or 80% in the “Unexplained Capex” or “gross profit overstatement” estimates respectively, there is still the suspicious inventory activity, as exhaustively covered by former CFO of Crazy Eddie, Sam Antar, in a series of posts titled: Is Green Mountain Coffee’s Inventory A Toxic Brew?, Is Green Mountain Coffee’s Inventory Approaching Toxic Levels?, and Green Mountain Coffee: Is It Toxic or Or Is It Phantom Inventory? These posts directly point to overstatement of inventory, understatement of cost of sales, overstatement of gross margins, and overstatement of earnings. While Antar used a completely different approach, he arrived at similar conclusions, which more than cover LST’s gross profit and net income overstatement estimates . Speaking of Antar, he made the following remarks in response to GMCR’s comment letter to the SEC:

QUESTION FOR GMCR MANAGEMENT AND GMCR BULLS LST strongly believes GMCR is either overstating its profits or misrepresenting its business as a “razor, razor blade” business for all the reasons described so far. LST wagers it’s more the former, and some of the latter. If someone, either from GMCR itself or one of GMCR’s bulls (for example, Goodnow Investment Group, Wellington Management, or Capital Research Global Investors) has an alternative explanation, please contact LST. If a satisfactory, alternative explanation is provided, LST will mail a box of (expired) kcups, flavor of your choosing. As a bonus, LST will mail 100 boxes of k-cups, if satisfactory explanations are provided to the above and below-mentioned concerns. The gross margin overstatement issue adds to a long list of problems, including but not limited to: 1. GMCR claimed it sells brewers to M. Block in its 2009 10K even as it omitted such language in its 2010 10K. Then in a response letter to the SEC, GMCR claims M. Block does not sell products. Reuters recently reported that M. Block has a history of doing business with sketchy concerns, such as the infamous, channel-stuffing fraud, Sunbeam & “Chainsaw Al”. 2. Certain numbers still don’t add up, even after restatements and an “internal investigation”. 3. Suspicious Insider selling activity since 2010, and well-timed purchases by certain controversial investment firms in late 2010, early 2011 (especially when GMCR needed $). 4. SG&A in 2011 post the Van Houtte acquisition didn’t reflect large increase in head count. 5. CFO Frances Rathke lied about being a CPA for nearly her entire career at GMCR (late 2011) in SEC filings. CEO Larry Blanford downplayed this in a February 2012 CNN interview. 6. GMCR never explained why they missed on sales last quarter. 7. “Next Generation” Vue Brewer are sold on eBay at substantial discount to retail price. 8. Patent expiration, new K-cup and brewer competition, etc. Pricing and volume pressure. 9. See MEMO TO GMCR MANAGEMENT and OPEN LETTER TO GREEN MOUNTAIN COFFEE ROASTERS’ BOARD OF DIRECTORS by LST for more. More to come…

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